Is the rupee really overvalued?

While the RBI’s real effective exchange rate of the rupee indicates that the currency needs to depreciate further, other indicators are not in agreement

The rupee is once again making headlines by repeatedly testing the 70 level against the dollar. And with this, the debate over whether the rupee has depreciated enough or should decline further, has also revived.

The importers are clearly unhappy about the impact of a depreciating rupee on their profitability. The economy is also going to face difficulty with widening current account deficit, reducing foreign fund flows, falling reserves and imported inflation.

But it’s clearly the exporters lobby that is more vociferous, stressing that the rupee is not competitive enough compared to its trading partners. Those supporting the stance that rupee’s depreciation is warranted, primarily cite the Real Effective Exchange Rate (REER) of the rupee to make the point that the rupee is overvalued in relation to its trading partners.

However a closer look at the construct of the effective exchange rates (EER) computed by the RBI shows that there are several shortcomings in the methodology. Also, the impact of technological progress on prices in developing countries and the cost of labour, if accounted for, can reduce the value of the broad trade-weighted REER of the RBI (currently at 115), that is oft quoted by all.

As a thumb-rule, if the REER or NEER’s value is above 100, it indicates that the currency is not too competitive, while a value below 100 implies better competitiveness. The rupee’s REER, computed by the Bank of International Standard (BIS), currently reads 100.3, implying that the rupee could be closer to equilibrium.

Also, the movement of the rupee’s nominal exchange rate over the long term shows that the rupee is among the worst-performing emerging market currencies over the last 14 years. An overvalued REER is at odds with this data.

Tracking the REER

The rupee’s REER tends to become the buzzword in periods when the Indian currency begins spiralling lower, as it is doing now. If you are wondering what this is about, effective exchange rates capture the movement in the exchange rates of home currency against a basket of currencies of trade partner countries. The NEER captures the exchange rate changes alone, while the REER adjusts the NEER for changes in price levels too. The REER is generally considered an indicator of international competitiveness.

The RBI’s six-currency trade-weighted REER with base year of 2004-05, that includes currencies of China, Hong Kong, the US, euro zone, Japan and UK, currently reads 123, implying that the rupee is overvalued by 23 per cent in relation to larger economies and China. But the NEER reading for this basket was 64 in July.

The RBI also published six-currency trade weighted NEER and REER with base year of 2016-17. The reading here is 96 and 98 respectively, for July 2018, implying that the recent decline in the rupee has made it more competitive.

The broader 36-currency trade-based REER index with base year of 2004-05, that tracks currency movement of other countries including many emerging economies such as Vietnam, Philippines, Brazil and UAE, currently reads 115. This is the head-line number quoted by all. The number seems to imply that despite the recent fall in the rupee, it is still overvalued by 15 per cent vis-à-vis its trading partners.

Problems with the REER

But it is debatable whether the REER, as computed by the RBI, is the right measure to evaluate the rupee’s competitiveness. Besides inherent short-comings of the REER metric itself, the method employed by the RBI is far from ideal.

The right weights?

The manner in which weights have been assigned to trading partner countries for calculating the EER leaves much to be desired. One, the RBI’s REER factors in trade in both manufactured goods as well as commodities to determine weights. This is not an ideal practice as trade in manufactured goods is more relevant for determining a currency’s competitiveness. Effective exchange rates, computed by multilateral agencies such as the Bank of International Settlement (BIS) and the OECD, take only trade in manufactured goods into account. The IMF, however, uses trade in both commodities and manufactured goods for computing the REERs of various countries.

Two, the RBI’s REER does not make sufficient adjustments for ‘third market competition’ and considers mainly bilateral trade weights. To explain third market competition, India exports as well as imports goods from China. But Chinese exporters also compete with India’s goods in many other markets such as euro zone or the US. So, the export weights assigned to China need to be adjusted to account for the competition in the third markets. BIS and OECD double-weight the exports to account for this.

The former Chief Economic Advisor, Arvind Subramanian, had pointed out this lacuna in the Economic Survey of 2016-17 where he said that the broader REER was assigning an ‘unusually high weight’ to the United Arab Emirates. UAE has 11.4 per cent share in rupee’s 36-country trade weighted REER. This is because of oil imports from these countries and they being a transshipment point for India’s exports. But this has no relevance to India’s competitiveness.

The euro has the highest weight of 12.7, though exporters from euro zone do not compete much with Indian exporters. If double-weighting were done to take into account third market competition, countries such as Vietnam, Bangladesh and Philippines and China will have a much higher weight in the broad rupee REER, since exporters from these countries compete with Indian exporters in overseas markets.

The EERs, as computed by all agencies, also suffer from some common defects such as difficulty in accounting for international vertical specialisation, wherein one country imports parts and ships out the final assembled product (such as China). The value added by each country is not easy to take into account in EERs. Secondly, the EERs do not take into account trade in services. While the IMF includes trade in services by assuming that it is geographically distributed in exactly the same manner as that in manufactured goods, limitation of data is an impediment here.

The IMF also releases EERs adjusted for labour cost. This ensures that the advantage of the countries with lower cost of labour is reflected in the REER. Lack of labour data could pose a challenge for RBI here.

The Balassa Samuelson effect

Luis A V Catao of IMF, while explaining the rationale for real exchange rates, wrote that there could be some structural changes taking place in developing economies that could be taking their REERs higher.

This assumption is based on the Balassa Samuelson effect that results in bringing down the price of tradeable goods in developed countries due to technological progress.

Due to international trading, the prices of these goods tend to move lower in developing countries, while prices of non-tradeable goods such as real estate and some services tend to stay elevated due to lower competition. Countries that have a higher proportion of non-tradeable goods in their CPI basket tend to sport higher REERs.

Housing and other services have around 38 per cent weight in our CPI basket. The rupee’s REER will have to be adjusted lower if the Balassa Samuelson effect is taken into account.

Catao writes that both theory and data support that much of the REER variations across countries are accounted for by fluctuations in the prices of non-tradables relative to those of tradeables, particularly so among developing countries.

The BIS REER

Currently, the IMF does not compute NEER and REER for India.

The BIS, however, puts out the effective exchange rate numbers for the rupee that can serve to compare the competitiveness of the rupee. The BIS’ broader index considers the rupee movement against 61 countries, uses double-weights to account for third market competition and takes only trades in manufactured products into account.

The BIS broad REER currently reads 100.39, which implies that there is no over-valuation in the rupee. In August 2013, when the rupee was under severe duress, the BIS’ REER for rupee had declined to 88.97, reflecting the under-valuation. In August 2007, when the rupee was on a roll, this index was at 102.3, reflecting mild over-valuation.

How does the rupee compare with other emerging market currencies in terms of BIS REER? This can be gauged by the Z-score (Z-score measures a value's relationship to the mean in a group. This is represented by the number of standard deviations the value is placed away from the mean value) of the BIS broad REER index for emerging market currencies, computed by Bloomberg. This indicator shows that the rupee is only slightly over-valued in relation to other EM currencies, with the rupee REER’s Z-score value at 0.83 on August 21, 2018, lower than the currencies of China, Thailand, South Korea and Taiwan.

One drawback of the BIS REER is that it uses WPI to deflate rupee’s NEER, while using CPI for all the other countries.

Our take

The question that needs to be answered now is – is the rupee overvalued?

It’s quite clear that the 36-country REER, calculated by the RBI, is not the right measure to judge if the rupee is overvalued since the manner in which it assigns weights to trading partners does not reflect the competitiveness of the Indian currency.

The BIS’s broad index for rupee is a better measure as it considers only trade in manufactured goods and assigns weights that take third market competition in to account as well. According to this measure, rupee is currently at its equilibrium value; at 100.3.

Also if the rupee REER, as calculated by BIS, is adjusted to account for the Samuelson Balassa effect and labour cost advantage in India, the BIS REER could move below 100. The current equilibrium value of the rupee is therefore likely to be between 68 to 72 against the dollar.

It needs to be noted that while the RBI’s Nominal Effective Exchange Rate of the rupee for the 36-currency trade-weighted basket currently stands at 73.87, the BIS’s broad NEER for the rupee is also quite close at 74. Both seem to imply that, in nominal terms, the rupee has corrected more than its trading partners.

This is proved by numbers too. If we consider the movement of the currencies of the emerging economies since 2004-05 (the REER’s base year), the rupee is among the worst performers, down 38 per cent against the dollar and 33 per cent against the euro. Other Asian currencies such as the Chinese yuan, Thai Baht, Singaporean dollar etc have appreciated around 20 per against the dollar and more than 25 per cent against the euro in this period.

The higher reading in REER could partly be due to slower decline in India’s CPI compared to its trading partners. But even then, the rupee REER is more likely to be closer to BIS’ REER.

The claim by the exporters that a weak rupee helps Indian exports can be refuted too. Empirical data shows that export growth has been robust in periods when the rupee appreciated. This was witnessed in the period between May 2002 and December 2007 as well as in the March 2009-August 2011 period.

In short, it would be wrong to conclude that rupee is not competitive, based on RBI’s REER number alone. Given that a weak rupee is not helping exports either, it will be better if policy makers give serious thought to whether they want the rupee to continue depreciating in this manner. The central bank also needs to recast its EERs to align itself to international practices and enable this metric to reflect the actual competitiveness of the currency.

What is REER?

Most of us individuals would be interested in knowing the exchange rate of the rupee in relation to the currency of another country. A country however trades with many other countries. So the home currency’s exchange rates with all the trading partners have to be taken in to account to judge the currency’s competitiveness. This is done by assigning weights to all the trading partners, depending on the quantum of trade with that country. The nominal exchange rate of the home currency with each trading partner country is multiplied by the relevant weight. This weighted average exchange rate is the Nominal Effective Exchange Rate. An index of these rates is computed from a base-year – 2004-05.

The real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the two countries. The core equation for real exchange rate is RER=eP*/P1, where, e is the nominal exchange rate, P is the inflation in home country and P1 is the inflation in the trading partner country. The RER is multiplied by trade weights and an index is composed of the weighted average to form the REER. The RBI is using the CPI to compute the REER from 2014; it was using the WPI earlier.

The RBI releases 6- and 36-currency trade and export weighted NEER and REER. The trade-weighted EERs use weights based on the total trade (imports and exports) while the export-weighted EERs use just exports for assigning weights. 3-year moving average trade and export weights are used.

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